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Riley: If Only Our Treasurer Knew How to Hedge Properly, Now Would be the Time

Tuesday, June 27, 2017


The “world is flat” as Thomas Friedman wrote in 2005 and remains so today. I have been managing money and portfolios of risk assets since the 1970s, keeping up with any news that could affect the markets was always critical for a risk manager like me.

Whether I was on the trading floor or managing director of a large Bank derivatives division or in my current role as a hedge fund manager, I have placed a premium on cutting edge trading software, access to news and analytics. My trading software was developed at Interactive Brokers Inc. by a friend Thomas Peterffy, augmented by my MIT genius partner but even their outstanding software combined with my experience doesn’t stand a chance to the high-speed trading and algorithms dominating today’s markets. There is no question in my mind that when dramatic news hits anywhere in the world  they will win and I will lose.

Last week I wrote about a few things that both traders and Investors should be concerned about even though risks are always present, I have always counted on liquidity, market access and reaction time to put on hedges to my portfolio, but in today’s fast moving markets I am becoming increasingly concerned that the next stock market crash in America will look like the “flash crashes” of several years ago when a “fat finger” or something else causes a sudden collapse in prices. Only this time they will not quickly rally they will just stay down or even close the market.

I have been professionally managing money and hedging portfolios nearly every day since 1979. I have been directly affected by every flash crash, or market event and so far I have been able to maneuver (that is hedge) almost all the time.

Things Changed in 2015

In August 2015, an unfamiliar disaster scenario became clear to me when suddenly the stock market became very soft and illiquid.

Stocks and underlying derivatives quotes widened dramatically while simultaneously the implied volatility (prices) of hedges exploded. It was as if a giant warning was sounded. Buyers of stocks disappeared and put prices exploded and then the combination of wide markets and high implied volatilities caused margin calls. My trading systems were frozen by interactive brokers until they could verify I had appropriate capital. This was happening to everyone. Not since Bear Stearns and Lehman Brothers in 2008 had I seen implied volatility rise to well over 200% annualized.

The strange thing about this sudden illiquidity was my experience with previous triple digit volatility markets 1987, 2000 and 2008 was that I recognized what was going on and why people were worried. In August of 2015 I had no idea what was happening. Fear came out of nowhere. The market wasn’t overheated at all, and all the talking heads were clueless as usual yet the losses were painful and we were frozen. 

Once I was helpless to hedge I was educated to another scenario where everything could suddenly go wrong. In my nightmares and in all likelihood I imagine the next crash will be swift and devastating.

The cause could be literally anything, a major bankruptcy/scandal (think Anbang in China), or housing collapse in Canada or Australia, an assassination or impeachment, who knows? My concern is that the markets are now so connected to each other and worldwide news sources that risk managers, AI deep learning computers  and other participants won’t take long to react and that their immediate actions will reveal the fragility of the market as well as  the underlying liquidity vacuum below. A week or month long 25%-30% sell-off could take place in a single day. The current period of market calm and record low implied volatility are evidence that portfolios are not currently hedged and instead are relying on liquidity to manage their downside risk. This will be a classic error.

In 1987, the popular imputation was that the newly popular “portfolio insurance” had caused the crash. Alas, the cause of the crash then in 1987 and the one that’s about to happen is too many investors were complacent and were forced to sell at the bottom. I’ve seen this happen over and over again. We saw the panic liquidation bottom in crude oil just 2 years ago in January and February 2015. Don’t be caught off guard! Most investors should get into a “comfortable and well hedged” position now so they can actually buy the market if it should drop 40% or so by year end instead of being frozen in fear.

Could it happen tomorrow? I doubt it, but I fear it and so should you.

Michael G. Riley is vice chair at Rhode Island Center for Freedom and Prosperity and is managing member and founder of Coastal Management Group, LLC. Riley has 35 years of experience in the financial industry, having managed divisions of PaineWebber, LETCO, and TD Securities (TD Bank). He has been quoted in Barron’s, Wall Street Transcript, NY Post, and various other print media and also appeared on NBC News, Yahoo TV, and CNBC. 


Related Slideshow: Timeline - Rhode Island Pension Reform

GoLocalProv breaks down the sequence of events that have played out during Rhode Island's State Employee Pension Fund reform. 

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In the five years before Raimondo was elected, pension changes included a decrease in established retirement age from 65 to 62, increased eligibility to retire, and modified COLA adjustments.
Read the Senate Fiscal Office's Brief here.
(Photo: 401(k) 2013, Flickr)
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January 2009

Governor Don Carcieri makes pension reform a top priority in his emergency budget plan. His three-point plan included:

1. An established minimum retirment age of 59 for all state and municipal employees.

2. Elimination of cost-of-living increases.

3. Conversion of new hires into a 401(k) style plan.


See WPRI's coverage of Carcieri's proposal here.

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Rhode Island increased mandatory employee contributions for new and current employees. New Mexico was the only other state to mandate current employees to increase their contributions. 


Read the NCSL report here

(Photo: FutUndBeidl, Flickr)

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Rhode Island's state administered public employee pension system only held 48% of the assets to cover future payments to its emplyees.

"This system as designed today is fundamentally unsustainable, and it is in your best interest to fix it" - Gina Raimondo


Check out Wall Street Journal's coverage here.

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November 2010

Gina Raimondo defeats opponent Kernan King in the election for General Treasurer of Rhode Island using her platform to reform the structure of Rhode Island's public employee pension system. She received 201,625 votes, more than any other politician on the 2010 Rhode Island ballot. 

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April 2011

Raimondo leads effort to reduce the state’s assumed rate of return on pension investments from 8.25 to 7.5%.

Her proposal includes plans to suspend the Cost of Living Adjustment (which allows for raises corresponding with rates of inflation for retirees), changing the retirement age to match Social Security ages, and adding a defined contribution plan.

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May 2011

Raimondo releases “Truth in Numbers”, a report detailing the pension crisis and offering possible solutions. She continues to work to raise public support for her proposal.

"Decades of ignoring actuarial assumptions led to lower taxpayer & employee contributions being made into the system." - Gina Raimondo (Truth in Numbers)


Read GoLocalProv's analysis of the report here.

Read the Truth in Numbers report here

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October 2011

Governor Lincoln Chafee and General Treasurer Gina Raimondo present their pension reform legislation proposal before a joint session of the General Assembly.

“Our fundamental goal throughout this process has been to provide retirement security through reforms that are fair to the three main interested parties: retirees, current employees and the taxpayer…I join the General Treasurer in urging the General Assembly to take decisive action and adopt these reforms.”- Gov. Lincoln Chafee

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October 2011

Head of Rhode Island firefighters’ union accuses Raimondo of “cooking the books” to create a pension problem where one did not exist. Paul Valletta Jr. states that Raimondo raised Rhode Islanders’ assumed mortality rate to increase liability to the state, using data from 1994 instead of updated information from 2008, and lowered the anticipated rate of return on state investments.

“You’re going after the retirees! In this economic time, how could you possibly take a pension away?” Paul Valletta Jr (Head of RI Firefighters' Union)

Read more from the firefighters' battle with Raimondo here.

Check out the New York Times' take on RI's  pension crisis here.

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November 17, 2011

The Rhode Island Retirement Security Act (RIRSA) is enacted by the General Assembly with bipartisan support in both chambers. RIRSA’s passing is slated to reduce the unfunded liability of RI’s pension system and increase its funding status by $3 billion and 60% respectively, level contributions to the pension system by taxpayers, save municipalities $100 million through lessened contributions to teacher and MERS pension systems, and lower the cost of borrowing.


Read more from GoLocalProv here.

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November 18, 2011

Governor Lincoln Chafee signs RIRSA into law. According to a December 2011 Brown University poll, 60% of Rhode Island residents support the reform. Following its enactment, Raimondo holds regional sessions to educate public employees on the effects of the legislation on their retirement benefits.


Read about how Rhode Islanders react to RIRSA here.

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January 2012

Raimondo hosts local workshops to explain the pension reforms across Rhode Island. She also receives national attention for her contributions to the state’s pension reforms.  The reforms are given praise and many believe Rhode Island will serve as a template for other States’ future pension reforms.


Read about the pension workshop here.

Read Raimondo's feature in Institutional Investor here

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March - April 2012

Raimondo opposes Governor Chafee’s proposal to cut pension-funded deposits. She continued to provide workshops on the pension reforms.

“The present law is sound fiscal policy and should remain unchanged.” -George Nee (Rhode Island AFL-CIO President)
See WPRI's coverage of Chafee's attempt to cut pension fund deposits here.
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December 5, 2012

Raimondo publicly opposes Governor Chafee’s meetings with union leaders in an effort to avoid judicial rulings on the pension reform package.  In response, Chafee issues a statement supporting the negotiations.


Read more about Raimondo's opposition here.

Read about Chafee's statement http://www.golocalprov.com/news/new-chafee-issues-statement-supporting-pension-negotiations/">here

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March 2013

Led by the Rhode Island State Association of Fire Fighters, unions protest the 2011 pension reform outside of the Omni Providence where Governor Lincoln Chafee and General Treasurer Gina Raimondo conduct a national conference of bond investors.


Read about Raimondo's discussion of distressed municipalities here

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April 2013

The pension plan comes under increased scrutiny as a result of the involvement of hedge funds and private equity firms. Reports show that $200 million of the state pension fund was lost in 2012.

"In short, impressive educational credentials and limited knowledge of investment industry realities made Raimondo ideally suited to champion private equity’s public pension money grab." - Ted Seidle (Forbes)


Read GoLocalProv's coverage of the State Pension Fund's losses here

Read Ted Seidle's criticism of Raimondo in Forbes.

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June 2013

Reports show that the State’s retirement system increased in 2013 by $20 million despite the reforms being put into effect the previous year.


Read GoLocalProv's investigation into the rising pension costs here.

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September 2013

Matt Taibbi publishes an article in Rolling Stone detailing Raimondo’s use of hedge funds as a questionably ethical tool to aid with pension reform. 

Read Taibbi's article in Rolling Stone.

Read GoLocalProv's response to Taibbi here.

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October 2013

As Raimondo eyes the role of Governor of Rhode Island in 2014, more behind-the-curtain information about the 2011 pension reform comes to light.


Read more from GoLocalProv about the players in the pension battle here.


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